The dangers facing the current financial system

It is now just over eight years since the financial firm Lehman Brothers filed for bankruptcy; still the largest in US history, and a moment which shook the world to its very core. The global financial crisis, of course, had already begun to assert its grip on the world, but the fallout immediately after the Lehman Brothers capitulation was immense, with panic engulfing inter-bank loan markets on both sides of the Atlantic, and many major commercial banks relying on bailouts at the expense of the taxpayer.

In the years since, the recovery has been sluggish, both in the UK and abroad. The credibility gap for bankers, and indeed the wider financial system, seems to have widened, and these chasms have led to widespread discontent. In the UK alone, such anger and lack of public faith in a flawed financial system arguably manifested such that it may have played a small role in events such as the 2011 Riots or the Brexit vote.

The structural weakness of banking

The uncertainty surrounding Deutsche Bank is a stark reminder of the fragile nature of the economic status quo. Of course, this particular situation has its own unique complexities, with the alarm bells sounding as a result of the US Department of Justice demanding around £11bn as a settlement for alleged mis-selling of mortgage-backed securities in the States. Deutsche Bank would barely have the capital reserves to cover this, thus thrusting it towards the precipice. Concern in the UK is that Barclays and RBS could also find themselves in the firing line.

Not all banks are contending with such headwinds. But all banks are, at their core, high-risk entities. They are highly leveraged, and while their assets are illiquid, their liabilities are anything but. By nature, this leaves them exposed to any turmoil, which is exacerbated by the fact that their balance sheets tend to be large too.

There is also a high degree of interconnectedness between banks themselves and their transactions with one another. This is precisely why even the more robust banks benefited from the post-crisis taxpayer bailout to those which were on the brink. For maintaining this level of solvency across the board ultimately kept the system ‘functioning’.

Penalties and monetary policy

The catch-22 of imposing penalties so severe on public institutions like banks such that it threatens their survival is far from a perfect solution. Furthermore, the issue to date is whether those most deserving of punishment are the ones who have actually been hit. Generally speaking, shareholders have borne the brunt of penalties dished out to the banks whose shares they own. But have management and key decision makers, who surely carried the buck to a greater extent for questionable practices, genuinely faced their day of reckoning? Certainly not on a mass scale.

The other point of intrigue has been the suggestion at the recent Conservative Party conference that quantitative easing could be reined in. Yet a tighter monetary policy will, at least temporarily, weaken the economy. Given how leveraged the banking sector is on the performance of the economy, it will likely make banks the weaker for it too, which could put Downing Street and the Bank of England on a collision course.

Fractional reserve banking

The biggest structural weakness of banks though surely has to be fractional-reserve banking. Albeit a principle adopted for centuries, it remains one of the more controversial elements of the banking sector. Quite simply, banks lend money each day which they do not have, as they are only required to keep a small percentage of customer deposits and notes as reserves (cash reserve ratio). This, in turn, causes the money supply to grow beyond the original amount created by the central bank.

This reserve ratio varies from country to country. In the UK, from 1981 until 2009, banks had the power to choose this figure (in coordination with the Bank of England (BoE)), and were charged for shortfalls and excesses relating to this target. Since the crisis, this target has been abolished. But with just a fraction of their deposit liabilities in store, the risk of bank runs is an ongoing one, and it came to pass most recently here with Northern Rock in 2007.

A long-term issue

It is excellent to observe the status quo being challenged by the likes of peer-to-peer lending platforms; entities which are free of the dangers of fractional reserve banking, and many others associated with the banking sector. However, as it stands, banks remain the powerhouses of the global financial system, and as they continue to be undercapitalised during a sustained period of poor global economic performance, taxpayer-funded bailouts continue to be a threat.

Let’s hope that with continued regulation, sound risk management, and a gradual decentralisation of power within financial services, our financial system can withstand these turbulent economic times and be restored to better health.

Michael Todt

Mike joined Lending Works in early 2015 with a background in marketing and journalism. Having long held a passion for economics, he is now the chief contributor to the Lending Works blog, and regularly writes about all things peer-to-peer lending, fintech and personal finance.